In Search of Solutions – An Interview with Dr. Lacy H. Hunt
We had the great pleasure of speaking with Dr. Lacy H. Hunt on the current state of the economy, the limitations of monetary policy and potential solutions to the overindebtedness problem in the main global economies.
Erico Tavares: Dr. Hunt, thank you for being with us today. Your firm manages over $6 billion in treasuries. With the S&P500 at record highs, do you share equity investors’ enthusiasm with the economic prospects of America?
Lacy Hunt: I think the S&P is disconnected from the fundamentals in the US economy. Growth last year was a quarter slower than it was in 2013. We’re on the cusp of either zero inflation or deflation. Corporate profits using the Bureau of Economic Analysis numbers, compiled using data from the Internal Revenue Service, showed year over declines in all the first three quarters of last year (4Q is not yet available). In the third quarter, the after-tax profits adjusted for inventory gains/losses and over/under depreciation were 7% below a year ago.
The standard of living declined again in 2014. And a lot of the growth we had in 2014 really was a massive building of inventories, which is often the case when stock prices are high and top line is decelerating.
The economy enters 2015 in very weak shape. None of the big ticket sectors are doing well. Capital spending is declining, being paced by extreme weakness in oil & gas drilling, which has really been the driving force in manufacturing over the last four years. The best you can say about the housing sector is that it is flat. Not a very important sector.
Vehicle sales are below the best levels of last year and the trade sector is deteriorating. It is very difficult to move the US economy forward by selling things over the counter and through the shopping cart. The US economy is very fragile. And the fragility is highlighted by the fact that firms simply do not have pricing power.
ET: Historically the S&P used to lead the economic cycle by a few months, sometimes there was a lag. In a sense the signaling of equity markets has been muffled by the excitement about central bank intervention. Is that correct?
LH: Well I’m not an equity investor but I don’t believe in the wealth effect. While a theoretical possibility, it is not supported by economic fact. Let’s go back and look at a few historical examples.
The stock market did not turn down in 1927 and then the Great Depression started two years later. The stock market only turned down in 1929 in the same year as the economy. The stock market didn’t turn down in 1998, two years before the recession. It turned down coincidentally. The fact of the matter is the stock market is not a very good indicator. The wealth effect is a theoretical possibility but no one can really measure it for the reasons that I discussed.
Another problem here is that the threshold studies done by econometricians who look at folks that have income less than $130,000 can’t even find a wealth effect and for good reason. These folks don’t have equity holdings. Upper income individuals do, but they are not income constrained. So the fact of the matter is the wealth effect is a theoretical possibility but nothing more than that. And the stock market is not a good guide to the economy.
ET: In a sense the search for yield pursuant to major central banks around the world pushing interest rates all the way down to zero has largely placed investors in the same side of the market. Just being moderately cautious has caused many equity fund managers to underperform their benchmarks, particularly since early 2013.
As long as central banks continue to pump money and maintain interest rates at zero, do you see it as inevitable that equities will just have to keep going higher?
LH: I’m a treasury investor and I can be anywhere in the curve. The Federal Reserve has made very significant pronouncements about economic growth. They have been overly optimistic at their final forecast in 2013 for 2014, projecting 3.2% growth which turned out to be 2.5%, and that may even be revised lower. Their inflation forecast was wide off the mark.
As treasury investors we can’t afford to listen to the Fed. As a matter of fact we positioned ourselves at the long end of the curve, and have been there for a long time, and during this whole time period they were talking very optimistically about the economy, inflation and so forth, and none of those materialized.
I’m only going to defend what is going on in the bond market and the bond market is a very good economic indicator. When bond yields are very low and declining it’s an indication that the same is happening to inflation and that economic activity is weak. The bond yields are not here for any fluke of reason. They are here because business conditions in the US and abroad are quite poor.
ET: Keynesian theory has pretty much dominated macroeconomic thinking over the last thirty years. Its “consume now, pay later” policies provide a short-term boost and fit well with politicians’ desire to prop up the economy on their watch. A large number of economists in government, private sector and academia, believe that adding more debt to a debt-inspired crisis is the only solution, and that at some point the economy will reach escape velocity and help pay down those debts.
Do you subscribe to this view, especially at these very high debt levels in the economy?
LH: I think that monetary policy at this stage of the game is largely bankrupt. There is certainly nothing that they can do.
Monetary policy works through price effects, quantity effects, the potential wealth effect and the currency depreciation effect. None of those mechanisms are operative.
The price effects don’t work because the short-term interest rates are at the zero bounds, so that’s out of the picture.
The US central bank, the ECB and the Bank of Japan have greatly expanded their balance sheets, but that’s not printing money. Money is an increase in deposits that are available to households and businesses. US monetary growth today is under 6% in the last 12 months, which is lower than when quantitative easing started. The Bank of Japan has doubled the monetary base in the last two years and yet M2 growth is 3% and a little bit more. The same is true in Europe.
Moreover, money alone does not determine economic activity. The velocity of money has fallen to a six-decade low in the US. It has been falling substantially in Europe, as in Japan. When you look at money growth and velocity it’s hard to see where nominal growth can be much better than 1% in Europe and Japan and no better than 2-2.5% in the US. Monetary policy does not benefit from quantitative effects when economies are extremely over indebted. The velocity of money falls and the banks are undercapitalized – banks don’t make loans based on excess reserves, but rather based on capital.
The currency depreciation option by excessive monetary liquidity does provide a transitory benefit. We saw this one when quantitative easing 1 was started in the US, but that’s a transitory benefit: other countries eventually retaliate making everyone worse off.
And the final option is the wealth effect but there is no empirical support for it.
So there’s really nothing that monetary policy can do and the fact that inflation in the US is substantially lower than when all of these quantitative easing efforts started is an indication that such policies are a bankrupt effort.
ET: So it seems that we are coming to the end of the rope here. We tried this one out, it did not quite work as the central bankers had expected it would, certainly the inflation is not here, but it did avoid a deflationary crash right?
LH: That’s not clear because the results are not in and the fact of the matter is that according to new research by the McKinsey Global Institute, as well as others like the Geneva Group, the world is substantially more levered now than at the time of the failure of Bear Sterns and Lehman. They calculate that public and private debt is now $57 trillion greater than in 2007, or 17 percentage points higher relative to GDP.
The overindebtedness buys a transitory gain in economic activity in lieu of a decline in future spending and, moreover, extreme overindebtedness cuts into the economic growth, it increases the risk of disinflation, if not deflation, and the fact of the matter is that the monetary efforts have probably made the world more unstable.
ET: It is said that organizations in crisis tend to repeat the same mistakes, only faster and with more intensity. Japan certainly seems to be following down that path with their latest rounds of aggressive quantitative easing.
LH: I think that’s an excellent example. In their panic of 1989 public and private debt was about 400% of GDP, more or less. It’s currently at 650% of GDP. They have greatly increased the indebtedness of the overall economy but the level of nominal GDP is no higher than it was 23 years ago. The results have been very, very poor.
ET: A grounded perspective might have prompted a rethink of the current stimulative policies, but it seems too many people are vested in the status quo. Given your extensive experience as a senior economist across a number of prominent institutions, including the Federal Reserve system, is this resistance to change something that concerns you?
LH: I’m not in the mind changing business; I’m in the investment management business. I am just trying to execute a fiduciary responsibility to our clients and we are operating under the assumption that quantitative easing will not be successful. We’ve operated under that assumption in the US.
Those who believed that economic growth would accelerate and that inflation would go up thought that investing in long treasuries would be a bad idea, and that notion did not pan out. Investors who saw the failure of quantitative easing, poor economic performance and low inflation were amply rewarded by being long long-term treasuries.
And so it is not my objective here to change how the world thinks. I’m trying to execute a fiduciary responsibility and that’s all.
ET: OK but let’s consider a non-conventional solution and how that might impact your current assessment. The major central banks could get together and say you know what, we have too much debt in our books, our economies are overindebted, let’s write off a chunk and move forward from here.
LH: Unfortunately those excess reserves are owned by the banks. If you wrote them off you would destroy a substantial portion of bank assets and the commercial banks and the other holders would go into a negative situation.
It is a flight of fancy to assume that these debts can be written off. That’s certainly not an option in the US, maybe the Europeans could do it but it would likely have the same effect. It is just not a realistic choice and it’s not practical. The banks are already terribly undercapitalized, you could not take away $3 or $4 trillion dollars’ worth of assets from the system.
ET: What about some good ol’ fashion money-printing? In other words, why doesn’t the government settle its debts with cash envelopes as opposed to having to issue more bonds? Of course this is highly inflationary, but isn’t deflation what the central banks are desperately trying to avoid?
LH: Here again, in the case of the US you would have to abandon the fractional reserve requirement system which I don’t think is doable. And I’m doubtful it is doable in Europe. We can talk about it as a theoretical possibility but it does not really exist as an option.
The fact of the matter is that a debt is an increase in current spending and decline in future spending unless the debt generates an income stream to repay principal and interest. More debt that is either unproductive or counterproductive is the path towards instability, disinflation and poor economic growth, not better economic performance.
ET: So how do you see all of this unfolding given the dearth of solutions at this point?
LH: I think it means we are in a protracted period of underperformance, minimal inflation, possibly deflation.
There are fiscal policy solutions, but they require shared sacrifice, explaining complex ideas to a public that is ill informed and strong political leadership, and we don’t have that in the US, you don’t have that in Europe, they don’t have it in Japan.
So for all intents and purposes fiscal policies is out of the game and in that environment the political sector turns to the central banks, but the fact of the matter is that the central banks’ bag of tricks is empty.
ET: Can you give an example of a fiscal policy that should be considered to address the problem?
LH: Well, you have to take advantage of the fact that we learned a great deal about the government expenditure multipliers and government tax multipliers.
We’ve learned that contrary to Keynesian theory the government expenditure multiplier is zero, if not slightly negative. So there may be a transitory benefit to deficit spending but it is so quickly reversed that ultimately an expansion in government expenditure financed with debt will make economies weaker. So what you have to do is scale back government spending, particularly those types of spending that go to finance daily needs. But that’s politically impossible to do.
And at the same time you basically need to shift income based taxes to consumption based taxes, but you have to address the regressivity of the consumption based taxes. The multipliers of consumption based taxes are minus one, the multipliers on income based taxes are in the minus two to minus three.
These concepts are too difficult for the general public to understand. So they really can’t be explained to them. And furthermore you don’t have the strong political leadership and it has to be done in the context of shared sacrifice.
So there are fiscal policy options but they are not achievable. Now occasionally you get into an unusual circumstance where an exceptional individual steps forward and the country understands the nature of its problem. A number of years ago Canada had a very far-sighted financial leader by the name of George Martin who developed a program of shared sacrifice and was able to turn the country around. But people bought on to the program because everybody’s ox was getting gored a little bit, and Martin had the rare capability of being able to explain the efficacy of the overall program.
I don’t see that happening in the US and Europe. Hopefully I am wrong on that, but the fiscal policy options are there although simply not achievable in the current environment.
ET: So a concern is that in Southern Europe people have been asked to make the sacrifice and implement austerity, but the results have been very dubious, where Greece provides an extreme example.
LH: I don’t think that was an effective program. You have to move away from the government expenditure programs, but at the same time you cannot contract your economy. You need to make a shift from income based taxes, which have a high negative multiplier, to consumption based taxes, which have a low negative multiplier, and you have to do this in the context of not increasing the debt of the government institutions. And that’s like trying to take a camel through the eye of a needle.
ET: You need a very good driver for that!
LH: Yes you do.
ET: Dr. Hunt, thank you very much for your time and your insights. This has been a really insightful discussion.
LH: That’s great, nice to be with you.